> I have some vague ideas of how the stock market works, but I'd like to hear the real answer from someone who actually knows. How does the stock market work? What changes the price of stocks? What stops it from collapsing at any moment? If wealth is created, musn't trading stocks actually provide a service of some kind?
>

The stock market works by supply and demand. Each common share of a company is an actual piece of that company, and when you buy a share you become a part owner.

What keeps the prices up? In part it's the fact that people are always buying in and hoping to later re-sell their shares at a higher price.

Another big part of valuation is the value of the underlying companies. The biggest of them all, General Electric, generated $16 billion in net income and $38 billion in cash flow from operations. What's a company like that worth to you? The market thinks it's worth almost $400 billion. When you buy a share, which is 1/10 billionth of GE, you're paying your share of the $400 billion to own a corresponding share of that profitable business.

Since you're a part owner of these companies, some of them will give you a cut of their profits. GE paid $8.5 billion in cash dividends to its shareholders last year. That's also a big part of what a company is worth. Many companies make it a point to pay out a certain percentage of their earnings as dividends, and to raise their dividends every year.

The regular payouts inspire confidence in the company, as well as providing an immediate benefit to shareholders. I guess you can consider dividends as a type of "service" that stocks provide. I certainly don't mind getting cash every year just for holding on to them.

A secure dividend is also part of what keeps a stock's price from collapsing. No matter how high or low the share price gets, there are a certain number of people who will hold on just for the income: retirees, income-oriented mutual funds, and investors who just like getting the cash. All of that restricts supply by tying up the "float", the number of shares available to be traded on the open market.

That said, some individual stocks do collapse from time to time. Usually it's because of surprising bad news about the company or because the company fails to meet investors' expectations. Either of those things may make you want to stop owning a part of that company, so you sell. Millions of other people also sell, but nobody wants to buy and the price drops. Once the price reaches a level some people are willing to pay, it stabilizes.

Look at what happened when Merck pulled VIOXX off the market. The share price dropped from about $45 to about $33, literally overnight. One thing that supported MRK at that level was the fact that it still had earnings and was still paying a dividend. After the drop, the dividend yield was better than what you could get from a government bond, plus some people were willing to bet on a recovery. MRK had an average volume of about 5 million shares a day but 145 million shares were traded that day, which shows you what happens when lots of people want to get out in a hurry. Supply and demand.

Fortunately, that type of event is rare, and by and large companies are worth about the same amount of money today as they were yesterday. This gives the system a level of stability, and inspires the confidence necessary for people to buy stock on a regular basis.

Plus, when certain companies get too cheap there are people and mutual funds with billions of dollars who are willing to buy large blocks of shares at a discount. General Motors had that happen recently. The stock was down from over $48 to below $25 a share, and all of a sudden Kirk Kerkorian decided he wanted to buy up to 28 million shares at up to $31 each. Since he made that announcement, GM has pretty much traded above $31, and Kerkorian only got 19 million of the 28 million shares he wanted. When you have that much money, owning shares is very much like owning the company, so these mind-blowingly rich people tend to support the share price at what they perceive as the value of the company as a business.

I don't own any GE, MRK or GM. They were just examples.

^v^:)^v^
F"hope this clears some stuff up"B